Are Loan Points a Tax Deduction?
How to Deduct Loan Points On Your Tax Return
By Julian Block, Attorney
Loan points sometimes get a bad rap, even when they might be tax deductible, and many loan points are if you follow the rules. Here's a good tip. Planning to buy a new home around year’s end? Try to wrap things up by Dec. 31. The reward for meeting that deadline is a tax deduction for this year if you have to finance the purchase with a mortgage loan on which you pay loan points.
How Do Loan Points Work?
What are points? They are additional, up-front fees, instead of higher interest rates. When money is scarce, lenders routinely charge points, also known by such designations as "loan origination fees," “premium fees,” or "loan discount;” one point equals one percent of the amount borrowed. If you borrow $300,000 and pay one point, you've paid $3,000.
How Do Loan Points Qualify as a Tax Deduction?
The key to loan points being 100 percent deductible in the year of payment, along with your other home-mortgage interest, is that you pay the points to obtain a specific type of loan. It must be a loan to buy, build or improve (as when you add or remodel a room) your main home, that is, your year-round home, as opposed to, say, a second home that you use as a vacation retreat or property for which you charge rent.
What Does the IRS Say About Loan Points?
Here is how the IRS reads the law when you refinance an existing mortgage.
Generally, refinancing points are not deductible in full in the year you pay them unless they are paid in connection with the purchase or improvement of a home. This is true even if the new mortgage is secured by your main home. Translation: Refinancers must write points off in dribs and drabs over the life of the loan — divide the points paid by the number of monthly payments to be made over the life of the loan.
To illustrate, you pay $4,000 in loan points and will make 360 monthly payments on a 30-year mortgage. Your allowable deduction is $11.11 per payment, or a total of $133.33 for 12 payments.
This IRS allocation requirement has been backed up by a 1988 Tax Court decision, though the Eighth Circuit Court of Appeals rejected the allocation rule when points are paid on a long-term mortgage that replaces a short-term loan with a balloon payment.
When refinancing a second time, or if the loan is paid off early, take a deduction in the payoff year for all remaining points not yet deducted. Wow! Who knew?
The law makes it easier for the IRS to check on whether a homeowner properly deducts points. The lender has to report to the IRS the amount of points, other than refinancing points, paid directly by a borrower. The amount must be listed on Form 1098. Like 1099 forms from banks and brokerage firms that report dividend and interest information, 1098 forms are sent to the IRS for use by its computers, which compare 1098 figures with amounts listed as deductions for points on Schedule A of Form 1040.
How About Seller Paid Loan Points?
Other complications kick in when you are the seller and pay points to induce the lender to arrange financing for the buyer.
You cannot count the points as interest. But as a selling expense, they reduce the amount of any gain you realize from the sale and are deductible by the buyer, who then must do some paperwork. He or she has to subtract the amount paid from the purchase price in computing the home’s basis — the figure used to determine gain or loss on the sale of an asset.
Are Prepayment Penalties Tax Deductible?
Be mindful of another wrinkle if you prepay the mortgage on a principal residence and are hit with a hefty penalty (a percentage of the unpaid balance) for the privilege of paying it ahead of time. No matter what the lender calls it, that extra charge is fully deductible home mortgage interest.
Julian Block is an attorney, syndicated columnist and former IRS special agent (criminal investigator). This article was excerpted with permission from the pamphlet: "The Home Seller's Guide to Tax Savings: Simple Ways For Any Seller to Lower Taxes To The Legal Minimum," which can be ordered by sending $19.95 for a postpaid copy to J. Block, 3 Washington Sq., #1-G, Larchmont, NY 10538.
At the time of writing, Elizabeth Weintraub, CalBRE #00697006, is a Broker-Associate at Lyon Real Estate in Sacramento, California.